A long-retired and dear friend keeps reminding me to watch out for the pains of tax liabilities when I reach retirement age (59 ½) and start making withdrawals from Traditional IRA type accounts. He discussed his own mistakes while speaking at length about the headaches surrounding said Traditional IRA or accounts of similar makeup such as the traditional 401k. This has prompted me to share some thoughts on the matter.
Note: There are many different types of retirement accounts as well as exceptions to the already complicated rules when it comes to the IRS, retirement accounts and taxes. Therefore, the information shared here should be viewed as a simple and generalized overview, limited to commonly known account types, so one should seek further information from a tax professional.
We tend to put money aside for retirement and do so mainly through tax deferred instruments such as the Traditional 401k types and Traditional IRA’s. One of the reasons for using such instruments is that they have been around for a long time and are therefore familiar. Additionally, they are often cheered for the fact that contributions made to these types of accounts use pre-taxed dollars, which means they may even lower one’s income tax bracket while allowing more of our money to work for us. However, the headaches are realized on the back-end, that is, during our retirement years when we are required to pay taxes on the earnings. Another hurdle is the fact that if one is fortunate to live past 70 ½, he is then forced to take a take minimum distributions from the traditional IRA type accounts, which could raise his income bracket at retirement. This is not the case for the Roth IRA types.
I have spoken of employer sponsored plans and the emergence of Roth 401k’s and indicated that it is the option I would have elected if given the choice when I was in the workforce. I would have also taken advantage of the Roth IRA vs the Traditional IRA. This is because even though these are after-tax contributions made to the Roth type accounts, I would not have to worry about taxes on those earnings in my later years or be forced to take distributions at any point. I would have the freedom to withdraw any amount at any frequency after reaching age 59 ½.
In short, the Traditional IRA type vehicles may be attractive on the front-end, but not so much on the back end, while the opposite is the case for the Roth type accounts. I prefer to deal with the headaches of taxes while I am younger rather than in my retired years.
Roth IRAs first became available in 1998 and were introduced as a vehicle to encourage retirement saving for those under a designated income level. If you have earned income and do not have a Roth IRA as yet, you may want to look into establishing one. The benefits are so attractive during retirement that people of higher income ranges are finding ways to establish such accounts and if you are in such a group, you may want to look into what’s called a Backdoor Roth Ira.
If you are close to retirement age, opening a Roth IRA is something you may want to examine with a bit more urgency because there are some restrictions after initially funding such an account. A big issue that is more important for those close to retirement is the 5 year rule, which requires the funded account to be in existence for 5 years before one can withdraw its earnings tax free, even after reaching 59 ½. Though there are a number of exceptions to this rule, of course, it is wise to plan the account with said rule in mind.
These days, more and more companies are offering Roth type sponsored plans such as 401K, 403b etc. as options in addition to the traditional types. If your company is not offering those at as yet, keep on checking because the idea seems to be gaining momentum.